Like many of you, I don't expect the markets to hold their current gains. Depending on the actual triggering event(s), a variety of options arise for investors who want to protect against a major pullback while generating some healthy income. Below, I took a look at how a Low-Correlation / Low Beta (LC-LB) portfolio of high-yielding stocks compares with a portfolio of well-know consumer staples as well as precious metal based dividend payers. The goal is to provide income-oriented investors with a basic"long-only" option to help hedge against a major pullback while generating income and maximizing the opportunity for capital appreciation. Each table uses five dividend paying companies, the SPDR S&P 500 ETF (SPY) & SPDR Dow Jones Industrial Average ETF (DIA) as proxies for major indices, and portfolio averages for comparison.
The first table contains a series of high-yield stocks with both low market correlations and low betas. As you can see, combined they provide an average yield above 9% with a correlation to the SPY and DIA of 0.41. Putting that into perspective, the correlation coefficient for the Pimco Total Return Bond Instl Fund (PTTRX) is 0.43 and 0.44 . However, as expected the PTTRX does offer a much lower beta with a mere 0.09, but by itself, yields almost 60% less at only 3.82%.
Low-Correlation / Low Beta (LC-LB)
Annaly Capital Management
Suburban Propane Partners
While there are a number of strategies that investors and advisors alike can employ to hedge against a pullback, the idea of using a "long-only" low correlation / low beta portfolio like this can be more enticing than venturing into short or leveraged ETFs, buying and selling options, or just waiting on the sidelines. That being said, it's important to compare and contrast this portfolio against other "long-only" considerations.
Historically, investors have sought safety from the pain and discomfort of a pullback through popular consumer staples that produce every day use items. But when comparing a series of the most popular and widely held companies to the LC-LB portfolio, the blue-chippers not only fall short in terms of yield but also when it comes to diversification (correlation) and volatility (beta).
Johnson & Johnson
Procter & Gamble
Precious metals like gold and silver can spell relief for investors during a market downturn, but depending on the cause and severity of the pullback, they may not serve as the ideal place to be. It's also important to consider that physical metals and popular ETFs like SPDR Gold Shares (GLD) or iShares Silver Trust (SLV) don't pay dividends. Therefore, investors who are seeking safety in something shiny and want to generate some income, need to do so with the major miners. Surprisingly, this group falls well short in each major comparison: yield, correlation and particularly beta.
In addition to these factors, investors should also consider the prospects for home-grown dividends, or the sale of shares to generate income / total return. Outside of Altria (MO) our Fair Market Value estimates suggest that the remaining companies within the LC-LB portfolio offer a compelling entry point whereas similar estimates for the staples are much less convincing. In our eyes, recent price appreciation in many of the staples has not only watered down their income prospects but also any near-term potential for capital appreciation at their current price levels.
On the other hand, the commodities portfolio may provide a similar opportunity for home-grown dividends, yet that possibility comes with a steep price tag in terms of volatility (beta). Moreover, if the market were to settle into a small trading range for an extended period of time (three months or more), very little income is available to help offset the other risks as compared with both the staples portfolio and LC-LB approach.
Our LC-LB portfolio offers investors a glimpse at how they can use volatility and diversification measures to protect against a market pullback while at the same time generating some healthy income and even the prospects for capital appreciation. The obvious downside to using this portfolio is the potential constraint it can have on upside moves. Therefore, investors should only allocate a small portion of their portfolio to this approach since low correlation / low beta alternatives can weaken long-term portfolio performance.